Will July 4th Weekend Bring A Rally? Or Panic? Or Both?

Time for a context check.

There will be a bear market rally at some point. The beginning of a bear market rally never feels good--usually you're so sick of the downtrend that you want to puke up your stocks at the first sign of better prices. Did we reach that point today? I don't know. I should mention that I didn't sell any of my short ETFs today, although I was tempted. What stopped me? The panic didn't seem panicky enough, and the buying didn't seem convincing enough. Also, the news that caused the rally was General Motors (GM) reporting higher sales than expected, a decline of 8.3% rather than the expected double digit decline. Listen, a decline of 8% in sales from an already weak company is not good news.

That said, the reaction to news is often more important than the news itself. The market, it seems, was looking for a reason to rally, so it did. The market's been going down--almost straight down--for around a month now. Sentiment is terrible, and the word "bear" is being used more than the word "bottom." These are ingredients for a counter-trend bounce. Even a smallish bounce could cause shorts to cover, which would push stocks up quickly. The sharpest rallies, they say, occur in bear markets.

Traders want a big capitulation day (extreme selling) and a huge reversal (extreme buying) to signal a turn in the bearish trend. This type of volatility is measured by the Volatility Index, a.k.a. "the VIX", a.k.a. the "fear gauge." As a rule of thumb, when the VIX is high, fear is high, and extreme VIX levels are usually good buying opportunities. In August, November, January, and March, the VIX hit 30, which is panic territory. That signaled a 2-month rally August 15-October 9 (+9.7% in the S&P 500), a choppy "sort of" rally November 12-December 10 (+4.3%), another choppy rally January 22-Feb 26 (+5.4%), and the sharp 2-month Bear Stearns rally March 14-May 19 (+10.8%). Bottom line: buying these spikes is usually profitable.

Here's a chart of the VIX--the peaks correspond to the start dates of the rallies. In the current round of selling, the VIX got up to around 25, but it hasn't yet scaled previous panic peaks--that could suggest we're not yet ready to rally.
And here's a comparison of the VIX and the Ultra QQQ (2x Nasdaq 100, ticker QLD) since January. You can see how the QLD and the VIX form a mirror image--VIX up, QQQ down.
There's another strange similarity between the last 3 trading bottoms: they all occurred around holiday weekends. November 12--Veteran's Day; January 22--Martin Luther King Day; and March 15--St. Patrick's Day. Put that in the "meaningless but interesting" category. Could we see the same situation play out around the 4th of July--the start of a rally during thin trade?

Again, I don't know. I did see several strong reversals today--a good sign for bulls. Gamestop (GME) hit my "pound the table" buy target under 40, and Starbucks (SBUX) had a "consider me interested" 15 handle. Both reversed and rallied to close in the green. I didn't buy either, partly because of the VIX, and partly because I'd rather buy strong stocks than weak ones. But I'm trying to keep in mind that many great opportunities don't "feel right" at the time. I'm also trying to keep in mind that there will be plenty of time to participate in the rally if it shows some legs.

Sorry to ramble on here, but I'd like to reiterate that we are in a bear market, and even if we see a tradeable rally, I think it will eventually fail--remember that when everyone starts saying "blah, blah, bottom, blah, bottom." The financials still have huge problems. The housing bubble has greater implications than the tech bubble, so we should see at least a similar level of pain over at least similar a period of time. Oil is an issue, and the Fed is in a box trying to stop it. Normally the Fed would raise interest rates to fight inflation, but that also hurts lenders (which are already hurting) and cools the economy (which is already cool). Normally the Fed would cut interest rates to encourage the economy, but that also spurs inflation (which is already high in people's minds). So the Fed has few options.

We could be facing a perfect storm of economic trouble. Todd Harrison of Minyanville spoke today of the potential for a major dislocation in the market, such as a 10% drop for the major indices in a few days. The thought of some type of crash or major panic has crossed my mind--no predictions here, just context. We could rally, we could crash, or we could simply grind along slowly. The point is, what are you and your portfolio ready for? And what if you are wrong? I ask those questions of myself frequently.

If you're wondering where I'm positioned, I'm about 50% in cash and bonds overall, including my long term retirement funds. In my more active trading portfolio, I'm around 25% cash, 20% short ETFs, and 13% Gold (GLD) and Natural Gas (UNG), which are obviously defensive / inflation plays. And I'm ready to adjust quickly.

Good luck out there.